EU referendum cover: coping with the mounting Brexit risk

One week ahead of the June 23rd EU referendum in the United Kingdom, the latest polls show British voters as evenly split. In this note, we review some of the tactical changes we have made to hedge our portfolio should a Brexit occur.

Context

While the Remain was ahead at the beginning of the campaign, recent polls show a shrinking lead for Remain. The results might partly be due to a greater share of online polls, which have typically shown stronger leads for Leave. However, it also seems that more voters are also favouring a ‘Brexit’. At the time of writing, polls are not only tied, but show a significant progression of the Leave:

• According to the latest YouGov EU referendum voting intention poll, 46% of voters would prefer to leave the EU while 39% are in favour of a Remain. The remaining 15% of the voters are still undecided.
• The latest ICM/The Guardian phone poll is in favour of a Leave.
• The latest ORB phone poll shows an almost 50/50 chance, while the online ICM poll also shows the Leave camp is ahead.

Given the rise in the Leave camp, the markets have started to react and are increasingly pricing in the Brexit risk: risk aversion is rising, stock markets are tumbling and the pound is depreciating. We have already reacted, as we were expecting an increase in volatility and uncertainty ahead of the referendum.

Strategy measures

Asset allocation strategy

The uncertainty of the result of the EU referendum in the UK for June 23^rd  has already guided our relative cautiousness in the recent months:

• We have reduced our equity exposure and implemented a tail-risk hedge with derivatives.
• Ahead of the votes in June (UK referendum, but also Spanish elections) and after a strong outperformance in May, we slightly reduced our equity overweight by reducing our exposure to euro-zone equities in favour of US equities. Also over the last few days, we have partially replaced our direct equity exposure by option strategies with a better risk-return profile. These strategies allow us to limit the drawdown and to benefit from a market rebound in the case of a ‘Bremain’.
• We have an underweight in UK equities.

Fixed Income strategy

In the run-up to the UK referendum, we have significantly reduced our risks.

• In terms of credit allocation, we have bought protection on credit derivatives & reduced our exposure to UK banks to neutral.
• We do not hold any overweight or underweight exposure on the GBP.
• In terms of interest-rate exposure, we have reduced our peripheral debt exposure (Spain – Ireland).
• Finally, we decided to buy exposure to UK inflation-linked bonds as a hedge against a sharp depreciation of the GBP in the case of a Brexit.

Equity strategy

In the light of the EU referendum in the UK, we stand by our current positioning:

• The underlying position we hold in British stocks has a global profile and is less exposed to the domestic economy. (Shire, Reckitt Benckiser, Johnson Matthey, Compass, Prudential, BHP Billiton, Halma). The only stocks that could be slightly affected are Lloyds and St. James’s Place.

• Other positions outside the UK have also mainly a global exposure. We do not hold any domestic stocks in the utilities or telecom sectors.

What if there were a Brexit?

An immediate response of the European authorities is key to containing further damage in the case of a Brexit. No doubt central banks will do “whatever it takes” by providing all the liquidity needed. The reaction of governments is, however, less certain and might be less immediate. Prime Minister Cameron might have to step down and general elections in the UK cannot be excluded. This could make negotiations more difficult with the EU.

We believe that, over a 1- to 2-year horizon, three scenarios could unfold:

• The favourable scenario (30%)

Governments immediately show a clear resolve to minimize the economic consequences of a Brexit. Central banks react in a coordinated way to dampen financial tensions. Within a few weeks, fears recede, risk aversion diminishes and markets bounce back. The economic impact of the Brexit remains contained.

• The “muddle-through” scenario (50%)

While central banks intervene to limit the negative impact of the Brexit, the response is deemed insufficient. Markets test “who’s next?” and contagion affects States where the EU membership could, in one way or another, be called into question. Faced with a deteriorating environment, the EU, however, avoids a full confrontation with the UK:  after some hesitation, governments and authorities convey the message that the Brexit consequences will not be dramatic. Confidence returns and, after a soft patch, activity reaccelerates and the markets progressively recover.

• The “European recession” scenario (20%)

A less favourable outcome cannot be excluded: after a few months, it becomes clear that European governments are unable to reach agreement in their negotiations with the UK and to agree on the need to support activity. Confidence is lastingly affected both in the UK and in the euro area. The markets remain depressed.

Note that one can easily move from one scenario to another. The rise in “Euroscepticism” could derail the democratic legitimacy of the whole European project. In this regard, the last scenario would, of course, be the most dangerous for the integrity of the EU.